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David Cay Johnston on “How to avoid a securities class action”

Pulitzer Prize-winning journalist and author David Cay Johnston has posted an opinion piece on Reuters providing some advice on “How to avoid a securities class action.”  He notes that research by Jonathan Rogers, Sarah Zechman, and Andrew Van Buskirk (available here) has shown that the risk of getting sued for stock price declines increases  when  the price drop is preceded by unusually optimistic statements about future earnings that is paired with insider selling. 

While this may seem somewhat obvious, Johnston notes that Gregory Roussel, who coaches executives on “how to talk up their companies without inviting litigation,” finds that certain executives are simply reluctant to tone down their enthusiasm.  Johnston goes on to note that overly enthusiastic executives may nonetheless find a reprieve by way of the “puffery” defense, which allows those accused of securities fraud to argue their misstatements were immaterial because they were essentially akin to a used car salesman telling a prospective buyer that the car at issue is “great.”  (For more on the puffery defense, you might want to check out David Hoffman’s “The Best Puffery Article Ever.”  David is also quoted by Johnston in his opinion piece.) 

However, Johnston cites my paper “Is Puffery Material to Investors? Maybe We Should Ask Them” for the proposition that judges are perverting the definition of materiality, which turns on what a reasonable investor would consider important, when they extend this doctrine to securities transactions too frequently.  In the paper, I argue that courts should survey investors before concluding as a matter of law that no reasonable investor would consider the alleged puffery material.  My own survey findings, which I discuss in the paper, suggested that judges are prone to doing a very bad job of predicting what actual investors would consider material.  Courts are already familiar with using surveys this way, as it is relatively common in Lanham Act cases.  

Regardless, Johnston ultimately concludes that:

[C]ompanies should make their insiders put proceeds from stock sales into escrow for some period of time — 90 days ought to do it — after upbeat executive statements. If the price drops during that time, make them take the lower price or wait until the price recovers.


Delaware, Confidential Arbitration and the Risk to Investors (Part 4)

As for the constitutional challenge to the system of confidential arbitration, a hearing was held yesterday.  A summary of the hearing is here.  According to statements at the hearing, six companies have used the confidential arbitration process. 


Delaware, Confidential Arbitration and the Risk to Investors (Part 3)

To the extent that a "consent" to arbitrate a "business dispute" appears in an operating agreement, members with claims against the entity may find themselves subject to confidential arbitration in Delaware.  Why does this matter?

Generally arbitration agreements (even mandatory ones) provide a mechanism for selecting the arbitrator that gives both sides a role.  Sometimes both parties must agree on the choice.  Sometimes they each select one arbitrator and the anointed arbitrators pick a third. 

With respect to FINRA actions, where arbitration is mandatory, parties receive a list of arbitrators and can strike those viewed as unacceptable. As FINRA provides:

for claims over $100,000, FINRA will send parties three lists of 10arbitrators randomly generated by the computerized Neutral List Selection System (NLSS)—10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. Under the majority-public panel method, each party may strike up to four arbitrators oneach list; under the optional all public panel method, each party may strike up to fourarbitrators on the chair-qualified public arbitrator list and on the public arbitrator list. However, under the optional all public panel method, each party may strike up to all ofthe arbitrators on the non-public arbitrator list. After striking arbitrators from the lists, theparties will rank the remaining arbitrators in order of preference and FINRA will appoint thepanel from among the names remaining on the lists that the parties return.

This is not, however, how things work with respect to confidential arbitration in Delaware. 

Rule 97(b) provides that upon receipt of a petition for arbitration, "the Chancellor will appoint an Arbitrator."  Arbitrator in turn is defined in Rule 96.  The term includes "a judge or master sitting permanently in the Court."  In other words, the parties will be assigned an arbitrator from those on the Court.

The identity of the arbitrators has been viewed as something important to "business citizens."  The amicus brief written by the Corporation Section of the Delaware Bar specifically noted that the loss of confidentiality for the proceedings would cause "business citizens" to seek alternatives, thereby depriving them of "efficient dispute resolution before their preferred expert."

These same arbitrators, while the "preferred expert" for "business citizens" may not be the "preferred expert" for investors or shareholders.  Members in an LLC who are subject to confidential arbitration may, therefore, find themselves in a forum with a decision maker that they otherwise would not have selected.   

Moreover, while the "consent" has appeared in operating agreement, it may eventually surface in a company's bylaws or articles, much the way mandatory venue provisions have surfaced.  See In re Revelon Inc. Shareholders Litigation, 990 A.2d 940, 960 (Del. Ch. 2010) ("if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes."). 

Shareholders, members, and other investors could, therefore, wake up and find that their disputes with the company were subject to confidential arbitration from an arbitrator that was the "preferred expert" of business citizens but not their preferred expert in a forum whereby the right of appeal is limited.  It may be a rude awakening.  


Delaware, Confidential Arbitration and the Risk to Investors (Part 2)

We are discussing the system of confidential arbitrations for business disputes that was recently put in place in Delaware. 

To take advantage of the system of confidential arbitration, the parties must consent, one must be a "business entity," a party must be organized under the laws of Delaware or have their headquarters in the state, and, where the action is seeking only monetary damages, must allege an amount of at least $ 1 million.  In addition, the provision does not apply to actions involving consumers.  Consumer includes "an individual who purchases or leases merchandise primarily for personal, family or household purposes." 6 Del. C. § 2731. 

Rule 96 defines "consent to arbitrate" as "a written or oral agreement to engage in arbitration in the Court of Chancery and shall constitute consent to these rules."  The definition also provides magic language that will trigger application of the system of confidential arbitration.  According to the Rule:  "[A] consent to arbitrate is acceptable if it contains the following language:  The parties agree that any dispute arising under this agreement shall be arbitrated in the Court of Chancery of the State of Delaware". 

Parties seeking to invoke confidential arbitration may, presumably, consent to do so at any time.  Consent may also appear in an agreement.  See COMPREHENSIVE SETTLEMENT AGREEMENT Between Versata  and Selectica, Sept. 2011 ("Any and all disputes between the Parties, whether arising out of the Agreement or otherwise, shall be submitted to binding arbitration in Delaware under the auspices of the Delaware Chancery Court pursuant to 10 Del. C. Section 349, with the proviso that the arbitration be heard before a current judge who shall render an opinion in accordance with the law."). 

There is nothing in the statute or rules that requires the consent to be in an agreement executed by two businesses.  Indeed, the provisions require that only one of the parties be a business.  Consents, therefore, may appear in agreements that involve individual investors or shareholders (although not consumers).  Moreover, these types of consents are beginning to appear in LLC operating agreements.  According to one Limited Liability Agreement:  

The Members hereby agree that any dispute among the Members or Committee Representatives as to how to proceed under this Section 7.4 shall be arbitrated in the Court of Chancery of the State of Delaware, pursuant to 10 Del. C. § 349 and the Rules of the Delaware Court of Chancery. The parties hereby submit to the exclusive jurisdiction of the Delaware Court of Chancery in connection with any action to compel arbitration, in aid of arbitration, or for provisional relief to maintain the status quo or prevent irreparable harm prior to the appointment of the arbitrator. 

Similarly, another Limited Liability Company Agreement provided that:  

Any dispute, claim or controversy arising out of or relating to this Agreement that cannot be resolved amicably by the parties, including the scope or applicability of this agreement to arbitrate, shall be determined by binding arbitration pursuant to Section 349 of the Rules of the Court of Chancery of the State of Delaware if it is eligible for such arbitration.

In other words, members of LLCs with disputes arising from their ownership interest may find themselves subjected to mandatory confidential arbitration in Delaware.  We will discuss why this matters in the next post.

Primary materials are located at the DU Corporate Governance web site. 


Delaware, Confidential Arbitration and the Risks to Investors (Part 1)

In 2009, the Delaware Legislature adopted Section 349 of the Delaware Code (House Bill 49).  The provision permitted the use of confidential arbitration in "business disputes." 

What made the provision unique was the identity of the arbitrator.  The provision provided that the Court of Chancery had "the power to arbitrate business disputes when the parties request a member of the Court of Chancery, or such other person as may be authorized under rules of the Court, to arbitrate a dispute."  10 Del. C. § 349. In effect, therefore, parties would get the benefit of one of the Chancellors/Vice Chancellors at the Delaware Chancery Court (or one of the court masters). 

The Chancery Court has adopted implementing rules.  Chancery Court Rules 96-98.  At least two companies have already made use of the Rule, filing a confidential arbitration with the Chancery Court.  See Form 10-Q, Mattersight Corporation, Nov. 10, 2011, at 14 ("On October 25, 2011, an arbitration hearing between the Company and TCV (as defined below) took place before the Court of Chancery of the State of Delaware").  Chancellor Strine presided over at least one of the proceedings.  As one public filing described:

On October 31, 2011, Chancellor Strine of the Court of Chancery of the State of Delaware, acting as arbitrator in the arbitration proceedings between Skyworks Solutions, Inc., a Delaware corporation (“Skyworks”) and Advanced Analogic Technologies, Incorporated (“AATI”) regarding the parties’ May 26, 2011 Merger Agreement (the “Merger Agreement”), held a hearing on Skyworks’ request (reported in the Current Report on Form 8-K filed by Skyworks on Friday, October 29, 2011) to file an amended petition alleging certain additional matters. After the hearing, Skyworks filed the amended petition.

The case eventually settled.

The adoption of the system of confidential arbitration that relied on members of the Chancery Court has generated controversy.  The Delaware Coalition for Open Government has challenged the constitutionality of the system.  The DCOG alleged that the system violated the First and Fourteenth Amendment.  In effect, the Complaint asserts that there is a constitutional right to access to trials and that the the approach adopted by Delaware violates that right.  According to the Complaint:

Del. C. §349 and Chancery Court Rules 96, 97 and 98 deny plaintiffs, and the general public, their right of access to judicial proceedings and records. Although the statute and rules call the procedure “arbitration,” it is really litigation under another name. Although procedure may vary slightly, the parties still examine witnesses before and present evidence to the Arbitrator (a sitting judge), who makes findings of fact, interprets the applicable law and applies the law to the facts, and then awards relief which may be enforced as any other court judgment. The only difference is that now these procedures and rulings occur behind closed doors instead of in open court.

As a result, the system, according to the Complaint, constitutes "constitute an unlawful deprivation of the public's right of access to trials in violation of the First Amendment as applied to the states by the Fourteenth Amendment to the United States Constitution."

The system and the case brought by the DCOG has already generated some commentary.  This includes posts at the ADR Prof Blog and Prawfsblawg

At the same time, the litigation has generated interest from interest groups.  Nasdaq/NYSE has filed an amicus on the side of Delaware, supporting the constitutionality of the system, as has the Corporation Section of the Delaware Bar Association.  An amicus has been filed supporting the position take by the plaintiff by the Reporters Committee for Freedom of the Press and five other news organizations. 

The first amendment issue is an interesting one but beyond the competency of this Blog.  While arbitrations are typically confidential, the main issue is whether, given the role of the Chancery Court, this is really an arbitration or a trial.  

There is, however, a significant issue with the Delaware approach that is within the competency of this Blog.  The approach may be available to require investors to arbitrate disputes with management.  We will discuss how this might occur in the next post.

Primary materials are located at the DU Corporate Governance web site.


SEC v. Gupta: SEC Charges Director, Hedge Fund Manager in Insider Trading Scheme

On October 26, 2011, the Securities and Exchange Commission (“SEC”) brought suit in Federal District Court against Rajat K. Gupta and Raj Rajaratnam, charging the two men with insider trading under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Section 17(a) of the Securities Act of 1933 (“Securities Act”).  The SEC previously brought an administrative proceeding against Gupta based on the same conduct; that proceeding was later dismissed.

According to the SEC’s complaint, Gupta was a member of the board of directors at Goldman Sachs and at Procter & Gamble in 2008 and 2009.  Rajaratnam managed Galleon Management, LP (“Galleon”), a hedge fund in which Gupta had a financial interest.  The SEC alleged that during 2008-09, Gupta disclosed material non-public information to Rajaratnam, who then traded on that information.  Gupta allegedly provided Rajaratnam with confidential financial information ahead of Goldman Sachs’ second and fourth quarter 2008 financial results, as well as tipping him ahead of the public announcement of Berkshire Hathaway’s third quarter 2008 investment in the company.  In addition, Gupta allegedly provided Rajaratnam with confidential financial information ahead of Procter and Gamble’s fourth quarter 2008 financial results.  Rajaratnam allegedly traded on the information. 

Under the “classical theory” of insider trading, an insider and outsider breach a fiduciary duty to shareholders when the insider knowingly or recklessly discloses material non-public information to the outsider, and the latter knows or should know of the breach.  The SEC alleged that Gupta learned insider information in his capacity as a director of Goldman Sachs and Procter & Gamble, that he knew or recklessly disregarded that the information was confidential, and that he provided the information to Rajaratnam with the expectation of a benefit.  Rajaratnam, in turn, allegedly knew or should have known that the information he received constituted a breach of Gupta’s fiduciary duties to keep the information confidential.

The SEC is seeking to permanently enjoin both Gupta and Rajaratnam from taking similar actions in the future, to bar Gupta from serving as an officer or director of a public company, and to enjoin Gupta from associating with broker dealers and investment advisers.  In addition, the SEC is seeking disgorgement of all profits and avoided losses stemming from the actions, as well as civil penalties. Gupta has sought to block the use of wiretap evidence in the case.

The primary materials for the case are available on the DU Corporate Governance website

A previous series of posts on the SEC’s administrative proceeding against Gupta is here.

Finally, Gupta's legal difficulties are not limited to the SEC case: the United States has indicted Gupta for conspiracy to commit securities fraud.


Lincoln Nat’l Life Ins. Co.: Life Insurance Policy without Insurable Interest is Void

In Lincoln Nat’l Life Ins. Co. v. Joseph Schlanger 2006 Insurance Trust, C.A. No. 178 (Del. Sept. 20, 2011), two separate insurance companies filed suit against two trusts, alleging multi-layered trust schemes that allowed a third party to speculate on the beneficiary’s life.  

In the case involving the Joseph Schlanger 2006 Insurance Trust, Lincoln National Life Insurance Company (“Lincoln”) issued a $6 million life insurance policy for Joseph Schlanger with the Schlanger Trust as the beneficiary.  This insurance policy contained an incontestability clause, which stated that Lincoln would not contest the policy after it had been in effect for two years from the issue date.  Schlanger died more than two years after the policy’s issue date, at which time Lincoln learned that Schlanger was no longer the beneficiary of the trust. Instead, Schlanger had sold his interest in the trust to GIII, a private investing entity.  GIII paid all the premiums and then used the trust to speculate on Schlanger’s life. The District Court for the District of Delaware consolidated this case with PHL Variable Insurance Co. v. Price Dawe 2006 Insurance Trust, C.A. No. 10-964-BMS (D. Del. Nov. 12, 2010), which also involved a life insurance policy that lacked an insurable interest.  The court then certified the following question to the Supreme Court of Delaware: “Can a life insurer contest the validity of a life insurance policy based on a lack of insurable interest after expiration of the two-year contestability period set out in the policy as required by 18 Del. C. § 2908?”

To answer this question, the Supreme Court of Delaware looked at the origins and purpose of the incontestability provision.  These provisions were first created to encourage potential customers to buy insurance policies.  Life insurance companies included these clauses to ensure that after the customer paid the premium on the policy for a number of years, the company would not contest the policy due to innocent misrepresentations in the application.  With this in mind, the court determined that the language of Section 2908 of the Delaware Insurance Code makes the incontestability period of the policy directly contingent on the formation of a valid contract.  Because this contract lacked an insurable interest and violated Delaware’s public policy against wagering, the policy was void ab initio under Delaware common law.  Therefore, the court held that an insurer “could challenge the enforceability of a life insurance contract after the incontestability period on the basis of a lack of an insurable interest.”

The primary materials for this case may be found on the DU Corporate Governance website.


NYSE Rule 452 and Voting Uninstructed Shares (Part 3)

The position set out in the NYSE Information Memorandum clarified that brokers will not be allowed to vote uninstructed shares for certain types of corporate governance proposals that are supported by management.  This recognizes that management support for a particular proposal is not always in the best interests of shareholders.  By eliminating the right of brokers to vote uninstructed shares in these circumstances, proposals approved by management will likely lose the automatic support that came from at least some of the brokers voting uninstructed shares. 

At the same time, this puts the NYSE in the middle of a potential quagmire.  Presumably the NYSE will have to define the particular proposals that fall within the definition of corporate governance.  This will no doubt entail an annual analysis.

The NYSE shift raises once again the question of whether Rule 452 ought to simply bar brokers from voting uninstructed shares.  The main advantage seems to be the need to have the shares present at the meeting for quorum purposes.  But this justification seems doubtful.  In some states, the quorum can be set at almost any percentage.  It is not uncommon for companies to have quorum percentages of one third.  See Del. Code § 216 ("in no event shall a quorum consist of less than 1/3 of the shares entitled to vote at the meeting"). 

Any company depending upon uninstructed shares to meet a quorum requirement of 33% has not done a particularly good job at getting shareholders to attend the meeting (by proxy or otherwise).   Moreover, the uninstructed shares could represent a sizable percentage of the 33% that are present at the meeting.  Because they cannot vote on many matters (corporate governance proposals, uncontested elections for the board, etc) the company is effectively deciding these issues through the vote of a very small percentage of the remaining shares.  It is not at all clear that a meeting should be held under these circumstances. 

At a minimum, the NYSE should conduct an empirical study to determine how often uninstructed shares are needed to ensure the presence of a quorum.  The data may suggest that they are not necessary.  To the extent, however, that they are, a second best alternative would be to allow shareholders to vote only on one matter, the outside accounting firm.  Most companies (but not all) submit the auditor to shareholders for approval.  The vote is never controversial and auditors are routinely approved with percentages above 95%.   For a more detailed discussion of shareholder approval of the auditor, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.


NYSE Rule 452 and the Problems of Uninstructed Shares (Part 2)

Rule 452 sets out the standards for voting shares by brokers.  It starts with the presumption that they can vote uninstructed shares then includes a list of matters that are excluded. 

The Rule has been at the center of controversy.  Most recently, the NYSE amended the Rule to prohibit brokers from voting in uncontested elections to the board of directors.  With majority vote provisions and "just say no" campaigns, votes by brokers in uncontested elections could carry dispositive weight.  In the "just say no" campaign against directors at Disney, some of the candidates apparently received a majority only because of the uninistructed shares voted by brokers.  Congress also stepped in by essentially requiring this result in Dodd-Frank. 

Most recently, the NYSE issued an Information Memo essentially containing further limits on the right of brokers to vote uninstructed shares.  The Memo noted that "[i]n the past, the Exchange has ruled certain corporate governance proposals as 'Broker May Vote' matters for uninstructed customer shares when the proposal in question is supported by company management."  Not any more.  Pointing out the "public policy trends disfavoring broker voting of uninstructed shares", the NYSE determined: 

that it will no longer continue its previous approach under Rule 452 of allowing member organizations to vote on such proposals without specific client instructions. Accordingly, proposals that the Exchange previously ruled as “Broker May Vote” including, for example, proposals to de-stagger the board of directors, majority voting in the election of directors, eliminating supermajority voting requirements, providing for the use of consents, providing rights to call a special meeting, and certain types of anti-takeover provision overrides, that are included on proxy statements going forward will be treated as “Broker May Not Vote” matters.

As a result, brokers will cease to have a role in the approval of certain types of corporate governance proposals.  We will discuss the implications of this proposal in the final post.


NYSE Rule 452 and the Problems of Uninstructed Shares (Part 1)

NYSE Rule 452 has always been a bit of an anomaly.  With the rise of street name accounts, most shareholders no longer hold record title to their shares.  Instead, they are held in the account of a broker (or bank).  The broker or bank typically transfers the shares to a depository, typically DTC.  So it is DTC that had record title to the shares.  

Under state law, voting rights belong to record owners.  DTC, however, does not want the voting rights.  Instead, the depository routinely (but not always) transfers voting rights to the brokers and banks that have deposited the shares.  At the time of a meeting, therefore, it is the broker that for the most part has the legal right to vote shares.

A complicated set of rules requires that brokers pass voting rights to street name owners.  They typically do so by distributing voting instructions to the account holders.  These instructions are executed then returned to the broker.  The broker will total up the votes and send the company a proxy card that reflects the views of street name owners.  For a discussion of this system, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The system gives street name ownes a guaranteed opportunity to vote at shareholder meetings even though they are not record owners for state law purposes.  Many street name owners, however, do not return their voting instructions.  Without some kind of regulatory or contractual intervention, brokers can vote the shares.  This gives them a potentially significant role in shareholder decisions even though they have no economic interest in the shares. 

The easiest thing to do would be a rule that bans brokers from voting uninstructed shares.  Opposition to this usually centers around the perceived concern that without voting the shares, they will not be deemed present at the meeting for quorum purposes.  To the extent a company lacks a quorum, it will have to reschedule and hold another meeting, causing additional delay and cost.

As a result, brokers are allowed to vote uninstructed shares.  Rule 452 delineates the circumstances where they are not allowed to do so.  Thus, if something is not listed in the Rule, brokers can vote the uninstructed shares.  Rule 452 in turn contains a complicated list of 21 items, including such matters as those relating to "executive compensation," something that, according to the notes, encompasses say on pay. 

The Rule has undergone considerable revision over the years.  An Information Memorandum issued by the NYSE effectively continues this process.  It prohibits brokers from voting uninstructed shares for certain corporate governance provisions even when supported by management.  We will discuss this interpretation in the next post.  


Sterling v. Nestlé: Defendant Lacked Injury and Therefore, Lacked Standing

In Sterling Merch., Inc. v. Nestlé, S.A., 656 F.3d 112 (1st Cir. 2011), the First Circuit Court of Appeals upheld summary judgment in favor of Nestlé, S.A. (“Nestlé”) for lack of standing. Sterling Merchandising Inc. (“Sterling”) sued Nestlé and its subsidiaries for violating the Clayton Act, 15 U.S.C. §§ 12-27, the Sherman Act, 15 U.S.C. §§ 1-7, antitrust laws, and various Puerto Rican laws.  On June 23, 2010, the United States District Court of Puerto Rico granted summary judgment in favor of Nestlé. Sterling subsequently filed this appeal.

In the complaint, Sterling alleged that Nestlé engaged in anti-competitive conduct from June 2003 through October 2009. Sterling contested the Nestlé merger with Payco Foods Corporation (“Payco”) in 2003 that made Nestlé the largest ice cream distributor in Puerto Rico and making Sterling the second largest distributor.  The Puerto Rico Office of Monopolistic Affairs approved the merger upon stipulated conditions. Sterling did not allege breach of any of those conditions.  Instead, Sterling presented a two-part injury and damages theory.  First, Sterling alleged that but-for Nestlé’s exclusivity agreements with a multitude of grocery stores, Sterling missed out on an additional $21-29 million in gross sales.  Second, Sterling alleged that Nestlé’s merger limited Sterling’s market share and caused a decrease in efficient operations.

The district court found that the Puerto Rico ice cream distribution market expanded during the relevant time period, the merger did not restrict output, consumer prices did not increase, and on certain products consumer prices actually decreased. The record also showed that before the merger, Payco and Nestlé had a combined 85% market share, and by 2007, the combined market share fell to 70%.  Sterling’s market share on the other hand, increased from 14.7% in 2003 to 22% in 2008.  Sterling’s sales, which declined $1.06 million from 2001 to 2003, increased after the merger at an average of 11% a year.  

To determine whether Sterling had standing, the court considered “(1) the causal connection between the alleged antitrust violation and harm to the plaintiff; (2) an improper motive; (3) the nature of the plaintiff’s alleged injury and whether the injury was of a type that Congress sought to redress with the antitrust laws (‘antitrust injury’); (4) the directness with which the alleged market restraint caused the asserted injury; (5) the speculative nature of the damages; and (6) the risk of duplicative recovery or complex apportionment of damages.”

The First Circuit applied the Supreme Court’s six-factor standing test, and emphasized causation of the injury.  The court reinforced that, “absence of ‘antitrust injury’ will generally defeat standing” and measured injury by a decrease in output and an increase in prices in the relevant market.  Sterling’s expert failed to show evidence that output within the Puerto Rico ice cream market declined or that consumer prices increased after the merger.  In addition to the findings that the Puerto Rico ice cream market statistics did not support Sterling’s argument, Sterling could not attribute any injury directly caused by Nestlé.  Sterling argued that a “plaintiff’s post-violation successes do not necessarily preclude compensation.” However, the First Circuit disagreed with Sterling’s alternatives to the classic evidence of antitrust injuries.

Sterling also failed to show the requisite injury. Under §2 of the Sherman Act, Sterling must show that Nestlé’s monopoly power prevented competitors from entering the market.  However, new competitors entered the Puerto Rico ice cream market after the merger.  Without establishing any injury to itself or to the competiveness of the market, Sterling’s claims lacked standing.

The primary materials for this case may be found on the DU Corporate Governance website.


The SEC, the Business Roundtable and an Appropriate Alliance

The Business Roundtable sought permission to file an amicus brief on the side of the SEC in the Citigroup case.  We have posted the brief on the DU Corporate Governance web site. 

At first glance, this may seem to be the case of strange bedfellows.  After all, it was the Business Roundtable that challenged the SEC’s shareholder access rule and essentially helped generate an opinion from the DC Circuit that will bedevil rulemaking endeavors for years to come. For an article criticizing that decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

But in fact the connection is a natural one.  To see the two as strange bedfellows is to see the role of the SEC as anti-business.  It is not.  The Commission’s goal of ensuring efficient capital markets benefits all participants.  It may be the case that in ensuring an appropriate regulatory regime the Commission sometimes tilts in favor of investors and shareholders.  But this is in large part a consequence of a shareholder unfriendly regulatory environment in Delaware.  It is a restoration of a necessary balance. 

Still, it seems as if the Business Roundtable and the SEC often find themselves on opposite sides.  Shareholder access is an obvious example.  What explains this?  It is not that one has a pro and the other an anti -business approach to regulation.  The difference is horizon. 

In the shareholder access case, those challenging access essentially sought to preserve the status quo.  The status quo is that directors are nominated by the board (often with considerable influence from the CEO, something chronicled in Essay: Neutralizing the Board of Directors and the Impact on Diversity) and elected by shareholders in a Soviet style contest (this is true even with majority vote provisions). 

As a result, directors often do not represent the interests of shareholders.  Under this electoral approach, there have been repeated breakdowns at the board level that have spurred calls for additional regulation, whether the failure to monitor for fraud that contributed to the pressure for Sarbanes Oxley or the failure to monitor for risk that contributed to the adoption of Dodd Frank. 

The status quo leaves in place a system that has resulted in a cycle of board failure followed by federal intervention and increased regulation.   Certainly this can be seen most clearly in the area of executive compensation, with the SEC now regulating compensation committees, overseeing say on pay, policing clawbacks, and banning practices that induce excessive risk taking.

Access alters the status quo but it also likely alters the cycle of board failure followed by increased federal regulation.  Access, under the model put forward by the SEC, limited the authority to long term investors and only permitted the election of a minority of directors on the board.  The presence of these directors in the boardroom would likely result in increased oversight of critical areas such as risk management and executive compensation.  Access challenges would also provide shareholders with an outlet for their frustration with management and reduce the need to seek a regulatory solution. 

Finally, the presence of shareholder nominated directors would probably stiffen the spine of the remaining directors and, at least in some cases, increasing the degree of oversight.  Under the current configuration, no one on the board wants a reputation as a trouble maker or someone who can be counted on to oppose the CEO.  This no doubt stifles genuine disagreement.  But if the disagreement is initiated by shareholder nominated directors, the others have more room to participate.

In other words, access holds the promise that by changing the status quo the inevitable dynamic of board failure followed by increased regulation will be allayed.  It is a long term benefit but one that trumps the short term consequences.  For now, however, the status quo remains in place and, as a result, so does the cycle of breakdown and regulation. 


Shareholder Access, Private Ordering and the Prescient Views of a Delaware Vice Chancellor

There is no question that one of the most unique and independent voices on the Delaware Chancery Court has come from Vice Chancellor Laster.  As a longstanding practitioner in Delaware, he knows the players and the plays.  His opinions often reflect a common sense understanding of the actual dynamics of shareholder litigation. 

This could be seen, for example, in La Mun. Police Emples. Ret. Syst. v. Morgan Stanley, 2011 Del. Ch. LEXIS 42 (Del. Ch. March 4, 2011).   This was an inspection case where shareholders sought documents that would look into the reasons why the special litigation committee of the board declined to bring a derivative suit in a "demand refusal" context. 

In the opinion, the context mattered.  He noted that when directors are asked to consider demand in a derivative context, it "typically happens" that they "refuse" to bring the action.  Moreover, plaintiffs are stuck with an almost impossible standard of review.  "[A] decision to refuse a litigation demand is reviewed under the business judgment rule, which forces a plaintiff to overcome the rule's powerful presumptions before a court will examine the merits of the directors' decision."  As a result, they are entitled to reasonable inspection rights.  "The highly deferential standard for reviewing a demand-refusal decision makes it critical that an accountability mechanism exist in the form of a limited right to information under Section 220."

This approach was also apparent in the Vice Chancellor's common sense remarks about the current debate on shareholder access.  The SEC adopted a shareholder access rule, only to see it struck down by the DC Circuit.  Whatever one thinks of shareholder access, the approach taken by the DC Circuit was analytically weak.  For an analysis of the decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

The decision eliminated mandatory access but purportedly left in place a system of "private ordering."  Shareholders are allowed to submit access proposals under Rule 14a-8.  So far this season, approximately 16 have been submitted. 

Yet the likely outcome of this "private ordering" approach is that management will resist and oppose access proposals, largely ensuring that they are not adopted.  This is because shareholders have little actual authority to "bargain" with management over corporate governance reforms.  See Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom

In other words, the outcome of "private ordering" in the shareholder access area will probably result in a categorical approach that does not permit access.  Access, however, is inevitable.  To the extent that the "private ordering" dynamics does not allow it to happen, shareholders will be forced to lobby regulators (the Commission and Congress) for reform. 

Vice Chancellor Laster recognizes these dynamics.  According to BNA, the Vice Chancellor, speaking on a panel at the AALS conference in Washington earlier this morning, "urged corporate America to take advantage of the Securities and Exchange Commission's new shareholder proposal approach to proxy access, or prepare for the return of a federal mandatory access rule." As he further stated, according to the BNA article:

“You asked for it, you got it, you better use it,” Laster continued. If not, institutional investors will lobby Congress for the return of a federal rule, he said. “In a Democratic administration, you're going to get something more detailed that won't have the same type of outcome” that Rule 14a-11 faced.

It is a common sense and correct view.  To the extent companies implement access provisions in a private ordering context, it will take pressure off the need for a Commission or congressional alternative, one that will likely be categorical and mandatory.  Yet this advice notwithstanding, the pattern so far has been for management to resist access rights.  The result has been greater SEC and congressional involvement in the area (witness the provision of Dodd-Frank that clarified the SEC's authority in the area). 

Perhaps this time matters will be different.  With the advice coming from a Vice Chancellor of Delaware, those in the boardroom may be more likely to listen.   

For more insight into the Vice Chancelor's perspective on Delaware law, there is a nice eight minute interview worth watching.


SEC v. Shields: Colorado District Court Denies SEC’s Motion for Injunctive Relief 

In SEC v. Shields, No. 11cv02121REB, 2011 WL 3799061 (D. Colo. Aug. 26, 2011), the District Court for the District of Colorado denied the Securities and Exchange Commission’s (“SEC”) motion for temporary restraining order and other emergency relief.

According to the SEC’s Complaint, Jeffory Shields (“Shields”) formed Geodynamics in September of 2009. Shields and Geodynamics created several joint ventures with Geodynamics as the “Managing Venturer” of each joint venture. The SEC alleged that the interests in the joint ventures were securities and that the securities were unregistered, in violation of federal securities laws.  According to the SEC, Shields and Geodynamics defrauded investors by promising each investor an annual return of 548%. The SEC also alleged that Shields spent over $2 million for personal expenses including a personal aircraft, luxury vehicles, and other items.

The SEC filed its Motion for a Temporary Restraining Order and Other Emergency Relief on August 15, 2011.  To obtain injunctive relief, the SEC was required to show that the Defendants violated a securities law “and that there is a likelihood of future violations.” The SEC was not required to show irreparable injury or the inadequacy of other remedies.   

The court relied on a three-part test to determine if an investment is an “investment contract,” and therefore, a security. For an investment to be an investment contract, it must be: “(1) an investment, (2) in a common enterprise, (3) with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The court focused on the third element. During a hearing on the issue, the Defendant presented evidence from Glenn Carroll, one of the joint venture’s partners. Mr. Carroll essentially testified that he did not rely on the efforts of the promoters.

The court considered both the credibility of the witnesses, the law presented by the parties, the parties’ briefs, documentary evidence, including affidavits, declarations, and exhibits, and live testimony in making its decision. The court considered several factors to evaluate witness credibility, including “the witness's means of knowledge, ability to observe, and strength of memory; the manner in which the witness might be affected by the outcome of the litigation; the relationship the witness had to either side in the case; and the extent to which the witness was either supported or contradicted by other witnesses or evidence presented.”

Ultimately, the court found Mr. Carroll to “be a particularly cogent, credible, and persuasive witness. . . .” Focusing on the third element of the “investment contract” test, the court held there was not enough evidence to establish that the Defendants’ investment was an “investment contract.” Therefore, the SEC failed to make a prima facie showing that the Defendants violated a federal securities law.  

Although the court denied the SEC’s motion for injunctive relief, it restrained and enjoined the Defendants from “destroying, mutilating, concealing, altering, or disposing of any document referring or relating in any manner to any transactions described in the Compliant.”  The Defendants are also prohibited from destroying any evidence of communications between themselves.  

The primary materials for this case may be found on the DU Corporate Governance website


Citizens United is about speech AND corporations

Noting the pending two-year anniversary of Citizens United, Kent Greenfield recently published an opinion piece in The Washington Post (HT: Gordon Smith) bemoaning the fact that, as he sees it, “the most prevalent critique of the decision — Corporations are not people! — is simplistic and dangerous.”  He notes that even if you dislike the opinion, the costs of stripping corporations of all their rights as constitutional “persons” would be too high.  Rather, he suggests focusing on alternative ways to lessen the impact of the decision:

The key flaw of American corporations is that they have become a vehicle for the voices and interests of an exceedingly small managerial and financial elite — the notorious 1 percent. That corporations speak is less a concern than whom they speak for and what they say. The cure for this is more democracy within businesses — more participation in corporate governance by workers, communities, shareholders and consumers. If corporations were themselves more democratic, their participation in the nation’s political debate would be of little concern and might even be beneficial.

I don’t feel any great need to contest either of these claims.  I do, however, want to comment on a couple of other statements Kent makes in the piece.  Kent notes that the reasoning behind Citizens United was that “the political speech of corporations was as important to the marketplace of ideas as the voices of human citizens.”  While I may seem to be nitpicking here, I believe it is important to add: “and there was nothing about corporations qua corporations to alter this conclusion.”  The reason I believe it is important to add this element is that, among other things, it calls into question Kent’s later proposition that:

The question in any given case is whether protecting the association, group or, yes, corporation serves to protect the rights of actual people. Read fairly, Citizens United merely says that banning certain kinds of corporate expenditures infringes the constitutional interests of human beings. The court may have gotten the answer wrong, but it asked the right question.

I would argue that the Court in fact failed to ask at least one of the right questions, which is: Given that there is a great deal of debate about what corporations are (or, perhaps more precisely, how best to conceptualize corporations), which theory of the corporation are you adopting in order to be so confident that there is nothing about corporations that justifies subjecting them to the established First Amendment exception for status-based restrictions on speech?  (In the interest of full disclosure, I have discussed this issue with Kent previously and I think I can fairly say that he was willing to grant that there was at least some merit to this point.)  I have argued previously (here and here) that there was essentially a silent corporate theory debate raging in Citizens United, and I am currently working on a project reviewing the key precedents leading up to Citizens United in order to see whether a similar debate can be found in those opinions.  Given that it is likely the Court will continue to be confronted with cases concerning the constitutional rights of corporations, I believe the justices will eventually have to affirmatively adopt a particular theory of the corporation to justify their conclusions or else begin to lose credibility for failing to do so.  Stay tuned.


U.S. v. Reyes: Defining Prosecutorial Misconduct

In United States v. Reyes, 2011 No. 10-10323 (9th Cir. Oct. 13, 2011), the Ninth Circuit Court of Appeals affirmed the defendant’s conviction for securities fraud, falsifying corporate books, and making false statements to auditors.

The defendant, Gregory Reyes, was the CEO of Brocade, a publically traded company that offered stock options to employees.  Mr. Reyes approved option grants to all employees, except for option grants for corporate officers.  In 2005, Brocade altered these policies and announced Mr. Reyes’ resignation.  These actions sparked an investigation by the SEC.  Ultimately the criminal authorities became involved and charged the defendant with having made false filings with the SEC under 15 U.S.C. §§ 78j(b) and 78ff, falsifying corporate records under 15 U.S.C. §§ 78m(b)(2)(A) and 78ff, and making false statements to auditors under 15 U.S.C. § 78ff.

After the first trial, the Ninth Circuit found prosecutorial misconduct and vacated the defendant’s conviction.  The court found the prosecution knowingly made false statements to the jury stating:

…the prosecution knew that several employees of Brocade’s Finance Department had given pre-trial statements to the Federal Bureau of Investigation acknowledging that the Finance Department knew about Reyes’s and the Company’s stock option backdating practices, but that during closing argument, the prosecution knowingly and falsely claimed that the Finance Department did not know about the stock option backdating.

After a second trial, the defendant claimed his conviction should be vacated because of additional prosecutorial misconduct and insufficient material evidence to support his conviction. 

Prosecutorial misconduct occurs when the government presents evidence to the jury that it knows is false or that it has strong reason to doubt.  This is designed to prevent the government from misleading the jury.  If the evidence introduced is not false and the prosecutor does not ask the jury to make false inferences from the evidence, there is no prosecutorial misconduct.

The defendant argued that the government introduced a false theory in the second trial when it asserted the defendant granted options for his own personal gain.  The court determined this theory was admissible because it was introduced to show the defendant’s motivation for granting the options. 

The defendant also claimed prosecutorial misconduct through the testimony of two witnesses, who the defendant claimed were only testifying to the backdating of options, which the government already knew was occurring.  The court determined that these witnesses were correctly allowed to testify because their testimony was not false, it was not used to mislead the jury, and it regarded their own experiences at the company.

The defendant argued his failure to disclose the option grants to investors was not material because it would not have altered their choice to invest.  Materiality is an element of securities fraud.  In order “for an omission to be material, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”  The court disagreed and found that the general investor would consider accurate accounting of a company material when deciding whether or not to invest.  The court therefore affirmed the defendant’s conviction.

The primary materials for this case may be found on the DU Corporate Governance website.


A Race to the Bottom?

First of all, I’d like to thank Jay for giving me the opportunity to blog here.  I’ve been a big fan of this blog for a number of years, and I look forward to hopefully making some positive contributions.  Given the name of the blog, I thought I’d start by addressing where I personally stand on the issue of whether the development of modern corporate law constitutes a race to the bottom or top.

The phrase “race to the bottom” is most commonly identified as tracing its roots to Justice Louis Brandeis in the 1933 case of Ligget Co. v. Lee:

The race was one not of diligence but of laxity. Incorporation under [competing state] laws was possible; and the great industrial States yielded in order not to lose wholly the prospect of the revenue and the control incident to domestic incorporation.

A fair starting point for the analysis is asking what we would expect to see if in fact the race for corporate charters constitutes a race to the bottom.  One fair answer is that we would expect the evolving laws to more and more favor the individuals making the decision of where to incorporate—that is to say, management.  And in fact, most commentators would agree that the state currently winning the race for corporate charters—Delaware—does in fact have what can fairly be described as manager-friendly law.

However, we clearly can’t end the analysis there because even though director-primacy looks suspiciously like what we would expect from a race to the bottom, it may in fact nonetheless also represent the most efficient allocation of power under corporate law.  A strong argument in favor of this proposition is that the market would not support an inefficient allocation of power.  That is to say, the cost of capital for managers incorporating in inefficient manager-friendly states should rise to the level of making incorporation there prohibitively costly.

The response of those who remain suspicious despite this rebuttal is often that markets simply aren’t efficient enough to impose the suggested sanctions.  One might point to various cognitive biases that have been identified by the adherents of behavioral economics, and argue that the typical investor is going to be overly optimistic, for example, in assessing whether the corporate law of the particular state of incorporation warrants discounting the expected rate of return. One may add that this should be particularly so in the case of retail investors as opposed to sophisticated investors, since sophisticated investors are often in a much better position to contract around many of the “overly” manager-friendly default rules.

Proponents of a race-to-the-top view might then respond that even if there are inefficiencies in the market, they do not rise to the level of invalidating the status quo.  That is to say, bluntly, do you have a proven better alternative?  While the recent financial crisis has led at least some to respond with, “Anything is better than this,” the more recent struggles of more socialist regimes, and the historic collapses of various communist and totalitarian regimes, do make it a fair question.  (I realize it’s a bit of a jump to go from director-primacy to socialism, but I hope you will take my meaning.  If one views the various constituency statutes out there as a form of socialism, the criticism holds because it is hard to rebut the contention that those statutes do little more than provide additional cover for management.)

So, where does all this leave me?  I guess I’m currently an agnostic believer in a race to the bottom.  That is to say, I don’t claim to know as a matter of fact that the evolution of corporate law in the U.S. has left management with so much power as to be objectively inefficient, but my reading of the relevant cases (along with what I view as the excessive political influence of corporations and the ever-widening gap between rich and poor) makes me suspicious enough to happily come on board a blog called, “The Race to the Bottom.”

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